BULLETIN - National Bank of Pakistan

November - December 2006BULLETINECONOMIC

Contents

§ Editor’s Corner ii§ Pakistan Economy - Performance, Challenges and Prospects 4§ The Year 2006 12§ Quarterly Performance of the Banking Sector 2006 - Selected Banks 19§ Market Analysis 20§ Books Review 24

NBP Performance at a Glance


ii

Editor’s CornerDear Readers,

The ongoing consolidation of financial institutions worldwide is one of the most notable contemporaryfeatures of the financial landscape. Indeed the past few years have seen an acceleration in the process, asbanks responded to meet the changes in regulations and international standards.

Mergers and acquisitions in the financial sector are undertaken for a wide variety of reasons. In any givencase, more than one motive may underlie the decision to merge. Though the factors vary with organizationalstructure, over time and across countries, but generally include among others, greater efficiency, newtechnology, changing laws, diversification, broader range of products, etc.

Over the past two decades or so, financial regulatory frameworks in most major countries have shiftedfrom systems based on strict regulatory controls to systems based more on enhancing efficiency throughcompetition. With the process of liberalization and deregulation having been undertaken in many countries,a new operating environment has been created for the banks. Mergers and acquisitions are a major componentof the restructuring process. It is thought that banks that are better capitalized, are better placed to implementinternational best practices at governance, risk management, taxation, accounting and disclosure regulationsand subsequently they can graduate to a global scale. Increased size, allows banks to better serve largecustomers, increase product diversification, increase the market share, thereby making it easier to attractcustomers. Only those banks who can venture into business expansion and risk management have theopportunity to survive in the new financial environment.

Consolidation has dramatically altered the structure of banking in countries where it is being pursued. Inthe US for instance, since the mid 1980s, the number of banks has plummeted, thousands of small bankshave disappeared; in Argentina the period between December’95 - December 2000 was a period of heavybank consolidation, while in Brazil the consolidation drive that began in 1994 now seems to be comingto a close.

The banking sector in countries like South Korea, Japan, Taiwan and Singapore are continuing to improvetheir efficiency and competitiveness through consolidation. Japanese banking sector has undergone significantdomestic consolidation and some mega banks have emerged. In Taiwan, the number of banks has beenreduced either through mergers among the big state owned banks or by private sector acquisition of stateowned banks. In Malaysia, the first stage of consolidation reduced the number of banks from 55 to 10,while the second stage involves mergers between banks and their finance company subsidiaries. In SouthKorea, during the last decade some banks closed down because of large NPLs, while others with capitaladequacy ratio of below 8 percent BIS guidelines were taken over by the healthy banks. With the strengtheningof the financial sector in Indonesia, and government support, banks have become attractive investmentopportunities for foreign players.

The governments of the less developed banking markets have played an important role in improving theirrespective banking system. Policies have been initiated to encourage bank reforms so that banks are betterequipped to compete in the highly competitive market. As part of this process, consolidation is beingencouraged to strengthen financial institutions. China for instance has raised the limit for individualownership in a domestic bank. India is amending its banking policies to encourage mergers and acquisitionsamong the public sector banks and the Thai government called for consolidation to reduce the number ofcommercial banks.


iii

In Pakistan, the process of consolidation begun in 2000 has gained momentum. The liberalization of thefinancial sector during the 1980s and 1990s had resulted in the setting up of a large number of private banksand non bank financial institutions. However, this fragmented structure of financial system, had placed thesmaller banks and NBFIs with their small capital bases at a competitive disadvantage against the largepublic sector banks. To address these issues, a process of privatization and consolidation was adopted, withthe objective to have fewer but stronger banks capable of withstanding economic downturns.

Mergers/acquisitions got underway when the State Bank of Pakistan raised the minimum capital requirementsfor banks to Rs1 billion in the beginning of 2002. Few years later by the end of 2005, the SBP again raisedthe existing minimum paid up capital requirement for locally incorporated banks/DFIs to Rs6 billion tobe achieved in a phased manner by 2009. This put pressure on the medium sized and smaller banks.However, several measures were taken to help financial institutions achieve the increased capital requirement.The branch licensing policy was liberalized, thereby encouraging small and medium sized banks to increasetheir outreach and asset base. Tax incentives were provided and some amendments were made in the legalframework to facilitate and encourage voluntary compliance among financial institutions.

Consolidation that began in 2000 has since resulted in some 37 successful mergers involving some 85entities (figures as of 2005). More banks have since merged. Foreign banks have shown a been interest inthe domestic banking sector, and many of the mergers involve foreign participation. Given the goodperformance by banks, the overall growth in the economy, the large potential that exists locally, a generallyconducive economic environment which encourages foreign investment are some of the factors for attractingforeign banks. One sees consolidation to continue for sometime. Strengthening of balance sheet is imperativeto those who are in pursuit of expansion and gaining a market share. Banks that are unable to reinforcetheir financial stability through their balance sheet are likely to face difficult times in the increasinglycompetitive industry.


4

Pakistan EconomyPerformance, Challenges and Prospects

Pakistan has shown good economicperformance in the last couple of years. Reformscarried out over the last many years, throughliberalization, decentralization, privatizationand restructuring, in almost all sectors of theeconomy, are having a significant impact onthe economic performance. The growth hasbeen commended upon by both the IMF andADB in their recent country briefs on theeconomy. The IMF Executive Directors havecommended Pak is tan’s impress ivemacroeconomic performance since 2001. Theywelcomed in particular the acceleration inoutput growth, the steady decline in debt ratios,and the fall in poverty rates. The country hasbeen made increasingly attractive to foreigninvestors as shown by the record high inflowsof foreign direct investment during 2005-06.The ADB in its latest economic updatecommenting on the medium term outlook termsit as positive.

The economy maintained a growth of 6.6percent in FY06, driven largely by the growthin the services sector. Despite an improvementin the availability of water, agricultural creditand greater use of fertilizers, unfavourableweather conditions had an adverse impact onmajor crops, sugarcane, cotton and wheat,which consequently lowered agri growth. Thecontinued price disputes between farmers andsugar mills affected sugarcane output whichwas lower for the second consecutive year. Theagricultural growth declined to 2.5 percentagainst 6.7 percent a year earlier. It also affectedgrowth of agro based industries, particularlyof cotton and sugar.

Weak performance by the agricultural sectoralongwith capacity constraints in key industries,high energy costs and continued monetarytightening affected the growth of large scalemanufacturing. These factors pushed the GDPgrowth rate below, both against the 7 percenttarget for the year, and the growth of 8.6 percentachieved in FY05. GDP growth could havebeen higher, if it were not for the shortfallsuffered by the agricultural sector.

Agricul-turesuffers

The agricultural sector in Pakistan is consideredas a major determinant of overall economicgrowth and well being of the people, becauseof its significant contribution to GDP, exportearnings, employment and food availability.Sustained, reasonably high agricultural growthis essential to accelerate the overall growth andsubsequently reduce poverty.

Institutional lending for agriculture has grownin recent years, as the large commercial banks,alongwith the domestic private banks areplaying an important role in meeting thefarmers’ needs. Livestock is gradually showingan improved performance and grew by 8.0percent in FY06. With the government’ssupport to the sector, the increased activity seenushers well for poverty reduction, as it enablesthe landless farmers to generate income.

Performance of the agricultural sector hasimportant implications for rural poverty, aswell as for gross domestic (GDP) growth andexports. A paper, ‘Agricultural Growth andRural Poverty - A Review of the Evidence,Sohail J. Malik, Asian Development Bank 2005examines the relationship between agriculturalgrowth and rural poverty. In addition to thedirect effect of agricultural growth on povertyreduction, through an increase in farmer’sincome there is a much larger indirect effectthrough the linkages between agriculture andnon-farm growth.

Non-farm growth is closely linked withagriculture growth since peasant farmers spenda large portion of their incremental income onlocally produced non-agricultural goods, thusgenerating employment and income in adjoiningareas. The increased demand for non-farmgoods leads to a much larger increase inemployment, which is the main vehicle forpoverty reduction.

We see in FY06 agro industries textiles andsugar were hit by poorer harvests. The rise inoil prices negatively impacted the growth invalue addition by the petroleum industry. Giventhat these three sub groups account for 50

Agricult-ure andpovertyreduction

Goodeconomicperfor-mance


5

Automo-biles &electron-ics showgoodperform-ance

percent of LSM, and as their performancesuffered, the overall growth of LSM alsodeclined. Smaller industries like tea blended,cooking oil and vegetable ghee, beverages,paper and board, chemicals, leather, throughaccelerated growth had a positive impact onoverall LSM growth.

While automobiles and electronics, showedsome deceleration in growth, it was slight andon the whole this sub-sector showed goodperformance. Availability of consumer financingwas a major contributory factor for the stronggrowth.

Production of Consumer Durables(000 (Nos)

FY’05 FY’06

Cars 1300cc & aboveCars less than 1300ccJeeps & VansTrucksMotorcycles

AirconditionersDeep FreezersRefrigeratorsTV SetsElectric Fans

53.672.87.53.3

416.2

181.8179.0784.6908.8142.0

70.091.012.94.5

519.4

363.2185.7861.6966.5145.0

Servicessectorimpress-ive

Services sector recorded an impressive growthof 8.8 percent, providing a welcome fillip tothe economy. Its sub-sectors showed a mixedperformance. Transport and communicationsub-sector showed a significant growth duringthe year, because of significant private sectorinvestment in the sector. Growth in valueaddition by wholesale and retail trade showeda slight dip because of the slowdown ofcommodity producing sectors, but its share inservices inched upwards. Investment rose inthe sector because of larger trade activities inthe economy, rise in consumption as well as

changing consumption patterns of thepopulation. Finance and insurance continuedto show a healthy growth as profitability of thesector improved, a new Islamic bank wasincorporated and the proceeds received fromprivatization.

While the services sector contributes about 52percent to the GDP and employs about 35-40percent of the people, who are mostly poorand unskilled, it has remained a fairlyunderdeveloped sector. The government is nowseriously considering developing this importantsector. For the first time an initiative was takenby the Ministry of Commerce to organize aConference, Domestic Commerce - The MissingLink.

Proceedings of the conference were publishedin January 2006. The report is edited by Dr.Nadeem Ul Haque and Izzah Waqaar. Theobjective of the Conference was how tostrengthen domestic commerce; new approachesare needed which could subsequently becomepart of the economic growth strategy. Domesticcommerce includes retail and wholesale trade,restaurants and hotels, construction, transport,storage and communication, financial and realestate and personal services.

As the sector contains a large number of smalland medium sized enterprises and is the largestcontributor to GDP, the aim was to understandthe sector by finding out its problems, investingand developing it. It was felt that if domesticcommerce could be developed it would havea favourable influence on the economy’s growthrate and in poverty alleviation.

The Conference concluded with the observationthat the domestic commerce sector suffersfrom shortage of land for commercial use,law and order problems, inadequate legalframework for property rights and speedy landtransfers, inadequate transport, no warehousing,discriminatory taxation among other irritants.The Ministry of Commerce is developingnew approaches to strengthening domesticcommerce.

Domesticcommerceto bestrength-ened

Consumer Financing forConsumer Durables

June2004

June2005

June2006

1997.7 2358.4 1559.9Source: State Bank of Pakistan


6

DoingBusiness

2006rank

745489

126686519

14098

16346

Ease ofDoing BusinessStarting a BusinessDealing with LicensesEmploying WorkersRegistering PropertyGetting CreditProtecting InvestorsPaying TaxesTrading Across BordersEnforcing ContractsClosing a Business

2005rank

Changein rank

664493

120575918

14311716334

-8-10+4-6-11-6-1+3

+190

-12Source: World Bank

Each of the above mentioned items, has anumber of indicators, where Pakistan iscompared to the region. For some indicators,like the time it takes on average to launch abusiness, the costs involved, investor protection,or getting credit information, Pakistan is betterplaced compared to other countries in the region.It is also better placed against indicators whichshow the procedures involved from starting tofinal agreement between two parties and endingwith the delivery of goods. However, thenumber of procedures involved in starting abusiness, the costs involved in building awarehouse and obtaining necessary licencesand permits is higher compared to countries inthe region. It has more

Improvedinvest-mentclimatebenefitseconomy

Investorconfid-ence

Investor confidence in the economy is graduallyimproving and the investment to GDP ratiorose to 20.0 percent during FY’06 up from 18.1percent in FY’05. The increase is attributableto improved confidence of local and foreigninvestors in the economy, rising publicinvestment and higher credit to private sectordespite increasing interest rates. While thegovernment is taking measures to enhanceinvestor confidence and reduce the cost ofdoing business in Pakistan, there are somepressing issues like provision of low costenergy and other utilities and law and ordersituation which negates the measuresundertaken.

World Bank figures on Doing Business providesranking on ten topics that comprise the overallranking. For some items, Pakistan’s rankinghas improved in 2006 over a year earlier andfor others it has deteriorated.

rigid regulations in hiring of workers, and inpaying taxes, the number of payments anentrepreneur has to make is more in a givenyear, so is the time spent in preparing, filingand paying of these taxes.

While the government has taken measures torationalize tariffs, improve tax refund process,remove procedural bottlenecks, improve taxlaws, reform the banking system, more effortsare needed to provide low cost and uninterruptedenergy, and improve law & order situation. Thetime it takes to enforce a contract also needsto be improved.

Studies have shown that an improvement inthe investment climate affects factorproductivity. For example, firm levelperformance analyses carried out in a study,“Investment Climate and Firm Performance inDeveloping Economies” in EconomicDevelopment and Cultural Change. Volume 54October 2005, by Dollar D., M. Hallward -Driemeier and T. Mengistae have providedresults showing that the quality of theinvestment environment has a significant effecton productivity. Data collected from a largenumber of countries, including Bangladesh,China, India and Pakistan indicate thatimprovements in various aspects of theinvestment climate (including power outages,days required to get a phone line, days requiredto clear imports, and exports through customs,access to financing, unofficial payments, andmanagement time dealing with regulations)would lead to significantly high total factorproductivity (ie the efficiency with whichresources are used in production) growth.

More evidence on the importance of investmentclimate conditions in affecting Pakistan’sgrowth outcomes comes from a cross - countrydata used in a report, Pakistan Growth andExport Competitiveness, World Bank, April2006, to analyze the impacts of a subset ofmicroeconomic factors and of stabilizationpolicies on Pakistan’s recent growthperformance.

The results indicate that the investmentenvironment improvements -- in public

Rankingimprovesfor someindicators


7

Risingcurrentaccountdeficitandinflation

Exportsrise

Marketdiversifi-cation

Tradedeficitrises

Currentaccountdeficitwidens

infrastructure, government burden, governance,trade openness, and financial depth - effectedthrough the structural reforms since the late1990s have contributed to about 80 percent ofthe 0.70 percentage point increase in the realper capita GDP growth rate observed during2001-05 compared to the 1991-2000 period.The recovery growth from the stagnation of thelate 1990s and the stabilization policies are theother factors explaining the growth rate increase.

Worrying features for the economy are therising current account deficit and inflation. Asgrowth in the economy has picked up, therehas been a sharp acceleration in imports bothin FY05 and FY06. Substantial increase ininternational oil prices and other commodityprices, larger food imports and machineryimports raised the import bill to US $25 billion.The petroleum group contributed almost one-third of the total import growth. Import ofmachinery and raw materials to cater for theneeds of the growing domestic economycontributed almost 46 percent to overall importgrowth. It was felt that larger imports were onaccount of enhanced economic activity andthese would gradually decrease as theeconomy’s productive capacity increase.

Imports growth started declining in the secondhalf of 2006 and have continued to fall duringJuly-November FY07. This decline has beenacross the board, with the exception of thepetroleum group, machinery and other imports.

Meanwhile, exports rose by $2 billion in FY06over FY05. At $16.5 billion, states the SBPAnnual Report 2005-06, “the exportperformance is commendable given the strongcompetitive pressure from China, India andBangladesh in textile and clothing items,adverse impacts of anti dumping duty and lossof preferential access under Generalized Systemof Preference (GSP) in the European Union(EU) market, appreciation of exchange rate inreal terms against the trading partner currenciesand relatively lower growth in the textile sectorproduction”.

Exports were however, not able to sustain thegrowth recorded in FY06 and during July-November FY07 they dropped to a mere 5.2

percent, compared to the 22.3 percent rise inthe corresponding period a year earlier. A morechallenging economic environment, whereexports face increased competition post MFA(quota regime has ended, Pakistan has lostsome of the gains under GSP, which some keycompetitors continue to enjoy) alongwith highdomestic energy prices and infrastructuralconstraints have affected competitiveness.

Pakistan’s efforts at export marketdiversification has been limited. However,though small in magnitude there has been someexport market diversification in the countrieswith whom Pakistan has bilateral free tradeagreements, China, India, Sri Lanka, Malaysiaand SAARC. Pakistan’s trade policy regimehas gone through significant improvementsand rationalisation in recent years. The tariffrationalisation measures introduced, the gradualreduction of the maximum tariff rate, as wellas the number of tariff slabs, are aimed atlowering the overall average tariff level.Compared to the second half of the 1990s whenPakistan had one of the most highly protectionisttrade regimes in South Asia, the current tradepolicy regime is one of the most open in SouthAsia. Reforms continue to further reduce theremaining anti- exports bias, so to strengthenPakistan’s export activities, and foster broaderexport diversification, so Pakistan’s exportscan compete in today’s incressingly morecompetitive and integrated global economy.

The trade deficit had risen to US$8.4 billionin FY06. Services account deficit widenedbecause of increased trade activity, as well asthe continued expansion in the coverage offoreign exchange transactions routed throughforeign exchange companies. Outflow undertravel also accelerated sharply. Investmentincome witnessed a deficit, due to higher directinvestment outflows. Interest payments onexternal debt also rose.

Meanwhile, private transfers have risen bothon account of higher workers remittances andother transfers (transfers on account of exchangecompanies). As such current account deficitwidened to nearly $5 billion from $1.5 billiona year earlier. This has deteriorated further inthe current year.


8

Asian Development BankEconomic Update October 2006

IMF Country Report December 2006

State Bank of PakistanAnnual Report 2005-06

· Persisting high inflation.

· Relatively narrow growth base.

· Stagnant tax base, which has keptthe tax/GDP ratio in the 10-11%range for over a decade.

· Over reliance on import relatedtaxes.

· Widening external current accountdeficit.

· Reducing cost of doing businessimproving infrastructure, enhancinglabour skills, reducing unit labourcosts.

· Containing the external currentaccount deficit.

· Containing inflation.

· Obtaining foreign financingconsistent with external debtsustainability.

· Achieving a higher stock ofinternational reserves.

· Capacity constraints in large scalemanufacturing.

· Declining national savings.

· Increased gap between grossdomestic investment and savings.

· Growing current account deficit.

· Continuing high inflation.

· Emerging power shortages.

Key Challenges to the Economy

The deterioration in the current account deficitwas more than offset by an improvement inthe financial account, which recorded a surplusof $5.9 billion compared with only $446 millionin 2004-05. The improved position continuedin 2007 (July-November), as financial accountposted a surplus of $2.5 billion compared to$1.8 billion in the corresponding period a yearearlier.

This was made possible because of a rise inforeign direct investment. In FY06, it morethan doubled to $3.5 billion, including $1.5billion in the form of privatization proceeds.The leading sources of FDI were UK, USAand UAE. The $800 million Eurobond issuewas also well received.

In the past few years, FDI has flown in thetelecommunications, financial business servicesand oil and gas exploration. Other sectors suchas trade, power, textiles, have also witnessedincreased foreign investment.

The improvement in the financial account lastyear resulted in an overall surplus of $1.3 billionin the balance of payment. Substantial overallsurplus in the balance of payments raised

Financialaccountimproves

foreign exchange reserves held by the Statebank of Pakistan to $10.8 billion, at end June2006, which are sufficient to finance 4.5 monthsof imports.

The current account deficit was financedthrough non current inflows, such as, $1.1billion from the US for logistic support for theWar in Afghanistan and inflows of foreigndirect investment and foreign investment inequities. The ADB Outlook 2006 states, ‘theheavy reliance on these non recurrent andsometimes volatile inflows is a major issuefor sustaining such high levels of both importsand the current account deficit, highlightingthe Government’s need to strengthen theunderlying fundamentals of the balance ofpayments’.

Inflationary pressures eased somewhat in FY06,as Consumer Price Index (CPI) deceleratedfrom a peak of 9.3 percent in FY05 to 7.9percent, mainly due to monetary tightening aswell as measures taken to counter supplyconstraints. While food inflation halved, thenon-food component of CPI rose due to risingenergy costs. Domestic factors like domesticsupply shortages of wheat, sugar, pulses and

Inflat-ionarypressuresease


9

milk as well as strengthening of domesticdemand, exerted greater pressures on inflation.The Government’s policy of liberal import ofessential food items, announced in last year’sbudget paid off by augmenting domestic foodsupplies.

In the first half of the current fiscal year FY07,non food inflation shows a downward trend.This is reflected in the easing of core inflation.The non food non energy measure of coreinflation dipped to 5.5 percent in December 06compared with 7.4 percent YoY for thecorresponding month of 2005.

Despite a decline in non-food inflation, CPI inthe first half of FY07, is close to 8 percent andis a cause for worry. Higher than expected foodinflation impacts consumers especially thosein the low income groups. By pursuing a tightmonetary policy, the State Bank would containcore inflation through the remaining monthsof FY07. It is necessary if its impact issupplemented by measures to address foodinflation and high energy costs.

In recent years, there has been an improvementin the government’s fiscal account. Revenueshave witnessed a strong growth, owing muchto pickup in economic activity and growth ofimports. The collection from direct taxes hasbeen quite impressive and its share in taxrevenues have grown to nearly 33 percent.Good performance has been noted in voluntarypayments, collection on demand andwithholding taxes. Pakistan is heavily dependenton indirect taxes, with sales tax and customsbeing the major contributors.

With CBR tax collection in the last few yearscrossing the respective target, it has enabled

the government to follow an expansionary fiscalpolicy. However, some weaknesses persist. Thefiscal deficit as a percentage of GDP has risen,so have the primary and revenue balances,measured as a percentage of GDP. The SBPstates, “ in this context, it is important thatfiscal management be disciplined, especiallywhen there remain structural weaknesses in thetax system, including a narrow tax base, overreliance on import related taxes, privatizationproceeds, and potentially non-recurring sourcesof non-tax revenue.”

In the first quarter of the current fiscal yearFY07, there has been same deceleration in thetotal revenue collection, basically due to a dipin non-tax revenues. Tax revenues acceleratedbecause of an increase in the direct taxcollections by CBR. Sales tax and custom dutycollection declined. Slowdown in importgrowth, may make achieving the CBR taxcollection target a challenge.

Meanwhile, expenditures have risen, and therise in development expenditure is welcome.In the current expenditure category, whileinterest payments have risen in FY07, defenceexpenditure has been curtailed, creatingadditional fiscal space for developmentspending.

Expenditures have grown with an increase inthe size of the public sector developmentexpenditure. Also last year, PSDP surpassedthe year’s target, unlike previous years whenshortfall to implement it used to occur. Largepublic sector spending is likely to boost demand,besides improving the physical and socialinfrastructure of the country.

Challenges to the Economy

The government had undertaken wide rangingstructural reforms in almost all sectors of theeconomy to improve the country’smacroeconomic environment. This has broughtsignificant progress over the last six or sevenyears. The government is now faced with anew set of challenges. More reforms areneeded to sustain the improvement that hastaken place.

Non foodinflationfalls

Trends in Price Inflation 12 month moving average

Food Non-FoodGeneral

4

7

10

13

Dec

2005 2006Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

Revenuesgrow

Expend-itures rise


10

While earlier the challenge was how to reviveeconomic growth, the challenge today is tohow to sustain the growth momentum of 6-8percent per annum. The other issues facing thegovernment include among others, poverty,income disparities, lacking social progress,water issues, law and order, achieving theMillennium Development Goals, energy,reducing the savings investment gap, illiteracy.

Historically Pakistan has had a large savingsinvestment gap. In FY06 the gap was 3.6percent of GDP against 1.6 percent a yearearlier. At present the gap in being financedthrough higher foreign direct investment andremittances. But if the gap sustains it couldaffect macroeconomic stability. Thus, there isa need to improve domestic savings throughinstitutional arrangements and conducivepolicies.

Over the last 2-3 years, the Government hasconsistently increased pro-poor publicexpenditure under its poverty reduction strategyspelled out in the Poverty Reduction StrategyPaper. Higher allocations are being made tosectors like, education, health, populationplanning, water supply and sanitation, foodsubsidies, food support programmes, ruraldevelopment, low cost housing etc, sectorswhich have the greatest positive impact onpoverty. In addition to pro-poor budgetingmeasures, the Government provides safety netsfor the poor through transfers from the ZakatFund, Employees Old Age Benefits Institutionand Microcredit is being disbursed.

Poverty however, remains a serious concern inPakistan. While GDP growth has been muchmore than other low income countries, but ithas failed to achieve social progresscommensurate with its economic growth, therural poor continues to suffer from poorsanitation, access to water and schools andgender disparities . The National Commissionfor Government Reform created by thegovernment, has been established with theobjective to reform public administration toimprove these basic services for the citizens.

Achieving the Millennium Development Goalsby 2015 would require renewed efforts by the

Government, especially for goals where thecountry is lagging. At the Pakistan DevelopmentForum 2006, a paper ‘MDGs and HumanDevelopment,’ showed Pakistan lagging in 13of the 34 indicators monitored. Pakistan ishowever, committed to achieve MDGs.Accelerated growth within a balanceddevelopment framework would help achievethe goals.

Prospects

The government is expected to continue withthe economic policies it has pursued in the last6-7 years, infact these are promised to bestrengthened. The government’s reform agendafor the next five years, includes strengtheningof institutions, better tax administration,improving the competitiveness of the industry,further reform of capital market, strengtheningof physical and human infrastructure etc.

Over a short period of one year, the economyis expected to grow by 7 percent (in FY07) asthe commodity producing sectors pick up andthe services sector maintains its growth. Thishigher growth estimate is based on substantialincrease in investment last year, stabilizationin oil prices, measures undertaken in the Budgetto boost agricultural output, and heavier rainsare expected to increase output of waterintensive rice and sugarcane crops.

Substantial public sector investment in irrigationin the last few years and an increase in importsof agricultural machinery in FY06 are seen asboosting agricultural output, as well as the dutyfree import of tractors, enhanced subsidies onfertilizers, and the new package of incentivesfor the livestock sector announced in FY07budget. If weather conditions remain favourable,agriculture is projected to grow by 4.5 percentin FY07.

The industrial sector is expected to expand by9 percent, with large scale manufacturingexpected to grow by 11 percent, supported bynew investments in textiles, cement andfertilizer industries and a number of incentivesprovided in the Budget 2006-07. The largepublic sector development programme during

Sustaingrowth

Savinginvest-ment gap

Greaterefforts atpovertyreduction


11

the year would give a boost to constructionactivities. Relative improvement in foreigndirect investment (excluding privatizationreceipts) would boost the growth rate.

Inflation is expected to remain in the range of6.7—7.5 percent during FY07. The increase inCPI that has been seen in recent months isbecause of higher food inflation. While the fuelcomponent of CPI has eased in recent months,it was still higher in November 2006 over ayear earlier. Any downward adjustment indomestic oil prices would be reflected in adecline of this sub-index and subsequently inthe overall inflation rate. Only if inflation comesdown, would it give some encouragement tosavings and make exports competitive.

With the expected growth in the economy, andextension of tax net to real estate transactionand on some financial services, the tax revenuesare expected to maintain a double digit growth(even though there may occur some declinein receipts from import related taxes as importgrowth falls. The need for further tax effortsto raise the tax GDP ratio over the next fewyears is clearly needed particularly byimproving collections from the under taxedsectors of the economy.

Current expenditure may exceed the budgettarget because of:

· high defence expenditure due to ongoingoperations against militants and possibly.

· greater domestic debt servicing. Pro-poormeasures announced in the Budget are alsolikely to increase expenditures. As such theoverall fiscal deficit could increase to 5percent in 2007.

Import growth is likely to decelerate as oilprices stabilize and demand for consumerdurables decline because of higher interestrates. Tight monetary policy is likely to dampengrowth in domestic demand.

Exports are expected to grow as world trade isexpected to expand, the lower antidumpingduty on bed linen imports from Pakistan byEU will boost exports. Also the concessionsgiven by the State Bank of Pakistan for theindustrial as well as exporters to limit the costof borrowing and R & D support to garments,home textiles and fabrics offered by the Ministryof Commerce and Ministry of Textile Industrywould supplement the SBP efforts to lendsupport to exports. The ADB forecasts thecurrent account deficit to increase to $8.5 billionor 5.9 percent of GDP.

The growing current account deficit, inflationarypressures and power shortages are potentialrisks to the economic forecasts for the economy.


12

The Year 2006January

· The government announced an across-the-board 15.51 percent increase in gas pricesfor all consumer categories throughout thecountry, wef January 1, 2006.

· The federal government has decided to relaxrules for existing Independent PowerProducers (IPPs), encouraging them to addnew power plants to meet power shortagesin the country.

· In the light of the government’s decision toraise gas prices by 15.5% effective January1, the CNG Station Owners Association andCNG Dealers Association increased the CNGprices by Rs2.0 - Rs2.40 per kg.

· Over 90 knitwear and sweater units closeddown owing to a host of unfavourable factors,primarily high cost of production dueto hike in utilities’ prices during 2005.

· The NFC Award has been amended. Theprovinces, which currently were receiving42.7 percent of resources under the existingNFC award, would now be offered 45.33percent of the total resources. The amended6th NFC award would remain in force forfive years unless provinces come up with aconsensus to formulate the 7th award.

· The entire database of top five banks has beenbrought under direct access of the State Bankdespite resistance from these commercialbanks.

February

· Turkmenistan-Afghanistan-Pakistan signeda memorandum of understanding for a gaspipeline project; Turkmenistan will supply3.2 billion cubic feet gas per day to Pakistanfor a period of 30 years.

· Ferozsons Laboratories, a leading Pakistanipharmaceutical company and Bongo Group,Argentina’s largest pharmaceutical group

joined hands to set up Pakistan’s first biotechpharmaceutical company, involving aninvestment of Rs600 million.

· Habib Bank to acquire upto 20 percent sharesin Urmaqi City commercial bank’s operationsin China, having a capital of $100 million,an asset base of $2.1 billion and 1000employees.

· In compliance with the State Bank ofPakistan’s instructions, all banks introduceda Basic Bank Account facility to facilitatethe low income people of the country. TheBasic Balance Account allows a minimuminitial deposit of Rs1000 with no limit onminimum balance and no fee for maintainingit.

March

· The Asian Development Bank agrees toprovide $130 million loan from its OrdinaryCapital Resources for Balochistan DevolvedSocial Services programme to help achievethe Millennium Development Goals. Theloan is for 15 years, including a grace periodof three years. The Program is to beimplemented during 2006-09.

· Pakistan and China identified projects worth$12 billion, including the Islamabadinternational airport, oil refinery at Gwadar,Bunji hydropower project and Neelam-Jhelum hydropower project for Chineseinvestment.

· Habib Bank retrenches 2300 employees ofnon core services and outsourced non coreservices activity to reduce its highadministrative cost and create financialcushion for hiring specialized personnel toimprove its customer service.

April

· About 50 percent of local pharmaceuticalindustry, having a $1.6 billion market, isfeared to close down in 2007, following the


13

inflow of cheaper Chinese and Indian drugsin the market. Neighbouring countries wherecost of production is much less than Pakistan,have been able to make their finished drugscheaper than local products.

· France has pledged $94 million soft loan forthe reconstruction of earthquake-hit areas ofPakistan.

· USAID is to provide more than $1.5 billionin development assistance to Pakistan overthe next five years, to improve education,health, governance and economicdevelopment.

· The World Bank is to provide 'First NWFPDevelopment Policy Credit' of $90 milliontowards poverty reduction, improving humandevelopment and accelerating broad-basedeconomic growth through support of theprovincial government's medium-term reformprogramme.

· Privatisation receipts expected to quadrupleto $1.971 billion in FY06 as against $363million in FY05. In FY’05 the governmentreceived only two payments--$102.96 millionfrom Agha Khan Fund for EconomicDevelopment for Habib Bank Limited and$260 million from Etisalat as down paymentfor Pakistan Telecommunication Limited.

· Pakistan announced the realisation of debtcancellation/swap of over $650 million fromdonor countries, including around $392million from Canada against the expenditureson education.

· The government issued licenses to six newbike manufacturers for setting up assemblyand manufacturing of motorcycle plants inthe country. With the issuance of these newlicences, the number of motorcyclemanufacturers and assemblers in the countryhas increased to 46.

· Pakistan and Canada signed a Memorandumof Understanding regarding Pakistan-CanadaDebt Swap amounting to C$449 million.This is the highest ever debt conversion everundertaken by the Canadian government.

· The Asian Development Bank will offerUS$4 billion in 2006-08, to Pakistan, an alltime high development assistance.

May

· The unofficial trade between Pakistan andIndia has increased by 37 percent to $965million in 2005-06, following softening oftrade barriers. The Associated Chamber ofCommerce and Industry of India places theofficial bilateral trade at around $700 millionduring the year.

· The mid-term development plan of theAlternative Energy Development Boardincludes, development of wind and solarenergy to meet at least 5% of the totalinstalled capacity of 9,700 MW by 2030.AEDB will facilitate installation of 700 MWof wind energy near Gharo, Sindh by 2010.

· Pakistan and Iran decide to establish a JointInvestment Company with a capital of $25million to promote trade and economicrelations between the two countries.

· Pakistan and the United Arab Emirates havesigned three Memorandums of Under-standing for co-operation in development ofmega infrastructure projects. Permission hasbeen given to the Dubai Islamic Bank tooperate 50 branches in Pakistan.

June

· The Balochistan Coastal DevelopmentAuthority has been assigned the task ofpreparing a master plan for developing the1,100-kilometre long coastal belt in theprovince. Private parties would be urged toestablish recreational points at varioussuitable sites along the coastal area.

· A Rs1.315 trillion budget for fiscal 2006-07was announced with Public SectorDevelopment Programme of Rs435 billionand current expenditure envisaged at Rs880billion.

· The government plans an investment of $150billion under the Vision 2030 to ensure


14

additional power generation of 14,3310Megawatt by the end of 2030.

July

· In a major landmark decision, the federalgovernment gives complete financialautonomy to provincial and districtgovernments from July 1, 2006.

· Pakistan announced tariff concession onimports of 4,872 items from India and Sri-Lanka in the category of Non-LeastDeveloped Countries; and Bangladesh,Bhutan, Nepal and Maldives from thecategory of Least Developed Countries underSAFTA agreement.

· Manpower export from Pakistan declines toa significantly low of 91,700 in 2005compared to 225,000 in 2003.

· UK based International Islamic Relief Fundlaunched its Rs1.5 billion IntegratedDevelopment Programme for AJK andBalochistan to improve the health andhygiene conditions and provide cleandrinking water in the earthquake devastatedareas of AJK and inaccessible areas ofBalochistan.

· Trade Policy 2006-07 envisages an exporttarget of $18.6 billion and imports of $28billion, with a trade deficit of $9.6 billion.

August

· The government approves an alternativeenergy plan with main focus on import ofLNG and setting up of its countrywidenetwork to provide a cheaper source of fuelto industrial and domestic sectors. It alsoapproved a proposal of the PetroleumMinistry to cap private sector's 350 milliondollar investment for setting up of an LNGterminal at Port Qasim, Karachi.

· Toyota Indus Motor Company plans todouble its production capacity from 50,000units to 100,000 per annum by the year 2010,

a plan in line with industry's target to raiseits output from the current 215 thousandunits to 0.5 million by 2012.

· The World Bank rates Pakistan as the 10thmost attractive state for investment in theworld. Britain is second largest investingcountry in Pakistan.

· The government offers an eight-year tariffpolicy to the automobile industry and alsoapproves the establishment of a fund worthRs6 billion for competitiveness, technologyacquisition, research and development andsetting up of two auto clusters in its plan todevelop the sector on sustainable footings.

· World Bank's commitment to South Asianregion reached $3.8 billion during 2006ended in June. Pakistan was among the 10major borrowers of the Bank, receiving$1.498 billion of total $23.6 billioncommitments world-wide during the year.

· The federal government has shelved theprivatisation plan of Karachi Shipyard andEngineering Works and instead approved afinancial restructuring package.

September

· Standard Chartered Bank acquired UnionBank by purchasing 95.37 percent sharesfor $487 million. After the merger, the Bankhas been named as Standard Chartered Bank(Pakistan) Limited. It is now the largest bankin terms of paid up capital.

· The BOC Group plc, UK, which holds themajor equity in BOC Pakistan Limited, hasbeen acquired by Linde AG, Woesh Bades.BOC Pakistan was originally a 100%subsidiary of British Oxygen Companyestablished in 1986.

· National Bank of Pakistan has launchedPresident’s Rozgar Scheme for theunemployed Products developed under thescheme includes setting up of communityutility stores, community transport schemeand community communication centres. The


15

scheme will cost Rs12 billion to the nationalexchequer.

October

· Following the merger of Habib Bank AGZurich with Metropolitan Bank, the namehas been changed to Habib Metropolitan Bank.

· Oman Oil Company has acquired 49% stakesin Pakistan Orient Power Company Limited,the first IPP being set up under the privatepower policy 2002.

· The Industrial Development Bank of Pakistanaccumulates a loss of Rs25.96 billion.

· MCB Bank successfully raised $150 millionthrough the issue of 8.6 mn. GlobalDepository Receipts (GDRs). The GDRrepresented first such issue for a Pakistanicompany.

· The Government of Pakistan and NoorFinancial Investment Company of Kuwaitsigned a memorandum of understanding forsetting up of a $1.5 billion refinery projectat Port Qasim.

· Dubai Islamic Bank arranged sale of 'Sukuks',or Islamic bonds, worth $85.3 million fortwo companies in Pakistan, namely, KarachiShipyard and Engineering Works and SuiSouthern Gas Company.

November

· UK’s Department for InternationalDevelopment plans to double its assistanceprogramme to Pakistan from Rs27.6 billion(£236 million) for the current period 2005-08 to Rs56 billion (£480 million) for theperiod 2008-2011. Reducing poverty is amajor focus.

· The textile industry is reportedly downsizingits workforce to save costs following 10.5%decline in textile exports in the first quarterof the current fiscal year. Textile exportshave fallen from $2.75 billion in the firstquarter of FY06 to $2.46 billion in thecomparable quarter of FY07.

· The Ministry of Finance has agreed to payabout Rs8 billion that various governmentdepartments owe to Pakistan State Oil, topave way for the privatization of PSO byJune 2007.

· The Ministry of Finance issues standinginstructions to the State Bank of Pakistan toautomatically retire government debt to theextent of 90% of privatization proceedswithout seeking further guidance from theMinistry on individual basis.

· Under an agreement between Pakistan andSaudi Arabia, the Pak Gulf ConstructionCompany has undertaken to build Centaurus,a project comprising state-of-the artmultipurpose 7-star hotel, 316 residentialapartments, a commercial complex and alarge shopping mall in Islamabad at a costof $400 million.

· The Reserve Bank of India and the StateBank of Pakistan have principally decidedto issue licenses to the banks for openingbranches and offices in each others countrieson reciprocal basis. Three Pakistani banks,National Bank of Pakistan, Habib BankLimited and United bank Limited haveshown interest in opening their branches andoffices in India. Three Indian banks, the StateBank of India, Punjab National Bank andBank of India have sought approval tooperate in Pakistan.

· Zarai Taraqiati Bank has reportedly writtenoff Rs4.46 billion of irrecoverable loans of11964 defaulters. Of the total, Rs4.02 billionwere written off to 101 industrialists, while11863 small farmers were written off Rs400million only. The Bank has suffered financiallosses to the tune of Rs5.164 billion betweenJune 2004 to June 2006.

· The Cabinet Committee on Privatisationapproved Oil and Gas DevelopmentCorporation’s global depository receiptsthrough 10% shares trading on London StockExchange. The committee also endorsed theplan for offering 5% of the company’s sharesfor secondary public offering to retailinvestors in the domestic market.


16

December

· Standard & Poor’s Rating Services assigned‘BB’ long term local currency debt rating totwo Pakistan Investment Bonds totaling Rs7billion ($117 million) issued in October 2006and due in October 2021 and October 2026.These newly rated bonds having maturitiesof 15 years and 20 years carry coupon ratesof 10% and 10.5%.

· Unesco sees illiteracy on rise in Pakistan.The country is ranked second amongst thecountries of the World with highest numberof out-of-school children (6.5 million). Thenet enrolment ratio (NER) is less than 80%as compared to other developing countrieshaving NER of over 85%.

· National Tariff Commission has imposedprovisional anti-dumping duty ranging from3.79% to 21.02% on 219 Chinese exportersof Ceramic tiles and unfinished tiles on thecharges of dumping of tiles in Pakistan andcausing injury to domestic industry.

· The Balochistan Government has fallen intoa debt trap as its overdraft touched the highestever Rs16 billion in November, while interestpayments exceeded by Rs250 million permonth.

· A deal has been finalized for the sale ofPakistan Industrial Credit and InvestmentCorporation (PICIC) alongwith itssubsidiaries, the PICIC Commercial Bank,the Asset Management Company and 30%shares of PICIC Insurance Company, subjectto the approval of the State Bank of Pakistan.The sale of PICIC, would bring about Rs20billion in foreign exchange at a purchaseprice of Rs84/85 per share.

· Pakistan retired $830.2 million of externaldebt and liabilities during the first threemonths of the current fiscal year. Totalexternal debt and liabilities stood at $37.72billion at the end September.

· Agriculturists paid only Rs1.6 billion tax ontheir income during FY06. Agriculture sectorcontribute 23% to the GDP, but the tax

recovery from the sector remains below 2%.

· The State Bank of Pakistan allowed theamalgamation of American Expresscommercial banking business in Pakistanand Jahangir Siddiqui Investment Bank’sinvestment banking business into JS BankLimited. JS Bank Limited, formed as a resultof this amalgamation will operate as ascheduled bank.

· The Ministry of Commerce has revised thetrade deficit projections for the current fiscalyear from $9.4 billion to $12.2 billion inview of the rising trend in imports. TheMinistry projected exports at $18.6 billion,and imports at $28 billion in FY’07. Importswere later revised upwards to $30.3 billion.

· The State Bank of Pakistan has no plans todevalue the rupee after reports appeared inthe media that IMF had recommended 10%devaluation.

· The seven members of South AsianAssociation for Regional Cooperation(SAARC) have agreed to set up a SAARCRegional Food Bank to meet foodemergencies in South Asia.

· The Central Board of Revenue decides toreplace sales tax registration numbers withthe wef Feb 1, 2007.

· Pakistan decides to challenge the EU’s traderestriction measures adopted under thegeneralized system of preferences plusscheme and anti dumping duty on bed linenunder the WTO.

· Total foreign private investment in the firstfive months of FY07 rises to $2.1 billionfrom $1.02 billion in the comparable periodlast year.

· Al Baraka a Bahrain Islamic Bank to offer25 percent stake to the private sector.

· Paktel, the country’s fifth largest mobilephone operator decides to close its 16 yearoperation in Pakistan owing to tough marketconditions.


17

Economic Performance

GDP Growth

20

15

10

5

0

-5

2000

-01

2001

-02

2002

-03

2003

-04

2004

-05

2005

-06

2006

-07

(Tar

gets

)

(%)

AgricultureServices

Large Scale ManufacturingGDP

Industrial Investment

020406080

100120140160180200220240260280

FY00 FY01 FY02 FY03 FY04 FY05 FY060

200

400

600

800

1000

1200

1400

1600

Rs.

Bn

Gross Investment PrivatePublic Total Invesment

Savings & Investment

0

5

10

15

20

25


% o

f GD

P

Investment Gross Fixed InvestmentNational Savings Domestic Savings

Inflation

0

2

4

6

8

10

12


Gro

wth

%

CPI WPI GDP Deflator

Money Supply

0

5

10

15

20

25

30


Gro

wth

%

M1 M2

Interest Rates

0

5

10

15


(%)

Discount Rate Treasury Bills (6 Month)Call Money Rate

Lending & Deposit Rates

141210

86420


Dec

embe

r

Dec

embe

r

Dec

embe

r

Dec

embe

r

Dec

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r

Dec

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r

June

June

June

June

June

June

June

Wei

ghte

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vera

ge (%

)

Deposits Advances Spread

16

14

12

10

8

6

4

2

0FY00 FY01 FY02 FY03 FY04 FY05 FY06

Income & Unemployment

Gro

wth

%

UnemploymentIncome Per Capita


18

Balance of Payments

-10000

-5000

0

5000

10000

15000


$ M

n

Current A/c. Deficit Trade A/c Deficit Private Transfers (Net)

Export/Import Trend

-20

-10

0

10

20

30

40

50


Gro

wth

%

Exports Imports Exchange Rate Rs/$

Foreign Investment & Remittances

-150

850

1850

2850

3850

4850


$ M

n

Workers RemittancesPortfolio InvestmentFDI

Capital Market

-60-40-20

020406080

100120140


Gro

wth

%

KSE 100 IndexShare TurnoverMarket Capitalisation

Budgetary Deficit

Rs.

Bn

0

50

100

150

200

250

300

350


1

2

3

4

5

6

Deficit as % of GDPOverall DeficitRevenue Deficit

Federal Budget

0

200

400

600

800

1000

1200

1400


Rs.

Bn

Development OutlaysExpenditureRevenue

External Debt

0

10

20

30

40

50

60

70


$ B

n

Debt & Liabilities Debt % GDP

Domestic Debt

0

500

1000

1500

2000

2500

FY00 FY01 FY02 FY03 FY04 FY05 FY06510

152025

3035

4045

Rs.

Bn

Floating Debt Permanent DebtUnfunded Debt Debt OutstandingDomestic Debt % GDP

% G

DP


19

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3.2

3.6

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6.8

7.6

7.3

9.4

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2.9

4.1

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3.3

3.0

3.3

25.0

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7.3

8.5

7.9

1.5

1.6

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8.7

6.0

2.6

2.8

3.1

14.1

4.5

5.2

5.6

5.0

1.7

1.6

1.5

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6.6

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0.9

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1.2

15.0

5.0

5.1

5.4

5.4

1.3

1.1

1.3

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3.7

4.4

4.5

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1.3

1.6

1.8

7.8

2.4

2.8

2.7

1.9

0.6

0.6

0.6

4.3

1.2

1.3

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23.5

24.8

27.4

6.8

7.4

9.2

9.8

6.1

2.3

2.8

3.1

2.7

1.4

1.7

2.0

3.5

0.9

1.1

1.1

1.3

0.4

1.6

0.3

1.3

0.4

0.4

0.4

3.2

0.8

2.2

0.8

2.4

0.6

1.8

0.6

25.1

23.8

26.7

26.5

17.5

16.1

19.8

19.4

10.6

10.9

10.5

10.1

7.6

7.7

7.5

7.8

2.1

2.8

2.9

3.0

1.5

0.4

0.5

0.5

0.9

0.3

0.3

0.3

0.5

0.1

0.2

0.2

0.4

0.07

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0.4

0.1

0.1

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25.8

28.2

28.5

7.4

7.8

8.5

9.1

8.8

2.8

3.0

3.3

4.2

1.6

1.6

1.8

4.5

1.2

1.4

1.5

1.6

0.5

0.5

0.6

2.6

0.8

0.8

0.9

2.9

0.6

0.9

1.0

2.0

0.4

0.7

0.6

63.3

63.5

66.6

67.0

47.6

47.7

52.1

50.9

32.0

33.2

33.0

32.8

16.4

16.3

15.8

15.8

3.6

3.9

4.2

4.4

3.7

1.3

1.3

1.4

2.0

0.9

0.9

0.9

1.7

0.4

0.4

0.5

0.6

0.2

0.2

0.2

0.8

0.2

0.3

0.3

1.4

0.4

0.4

0.3

0.9

0.2

0.3

0.2

91.5

99.4

104.

810

7.9

75.8

80.5

84.9

88.0

55.3

59.9

60.9

60.7

19.8

24.7

26.3

25.7

4.7

4.8

5.4

5.7

4.9

1.7

2.0

2.0

2.1

0.8

1.0

1.0

2.8

0.9

1.0

0.9

1.0

0.3

0.3

0.3

1.7

0.5

0.6

0.6

2.0

0.6

0.8

0.6

1.4

0.4

0.5

0.4

248.

3

251.

626

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261.

5

222.

3

209.

220

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214.

8

118.

9

124.

312

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133.

8

57.4

80.4

81.6

68.2

6.7

7.1

7.6

10.1

12.2

4.9

5.2

5.5

7.2

3.6

3.7

3.7

5.0

1.2

1.5

1.7

2.2

0.8

0.7

0.8

4.3

1.3

1.4

1.6

2.6

0.5

0.6

0.8

1.7

0.4

0.4

0.5

117.

1

122.

012

1.8

113.

6

91.2

92.6

90.3

73.4

69.0

71.6

72.6

68.8

19.2

27.5

25.8

23.7

5.1

5.0

5.5

5.2

8.1

2.8

3.2

3.1

3.7

1.6

1.8

1.7

4.5

1.2

1.3

1.4

2.6

0.7

0.8

0.7

3.2

0.9

1.1

1.5

2.8

0.8

0.7

-0.3

1.7

0.5

0.5

-0.3

17.2

17.5

21.5

22.2

12.9

13.3

15.7

16.2

9.3

10.0

10.5

11.5

3.3

3.3

3.0

3.8

2.5

2.5

2.6

2.8

1.0

0.4

0.4

0.4

0.3

0.2

0.2

0.2

0.7

0.2

0.2

0.2

0.2

0.1

0.1

0.2

0.5

0.1

0.1

0.1

0.2

0.2

0.1

0.2

0.3

0.1

0.08 0.2

79.7

87.5

92.8

94.3

56.7

58.2

60.0

60.4

43.5

47.0

47.6

47.0

22.8

25.9

27.2

28.7

5.0

5.4

5.9

6.3

4.4

1.5

1.6

1.7

2.2

0.9

0.9

1.1

2.1

0.5

0.7

0.6

0.9

0.3

0.3

0.4

1.0

0.3

0.3

0.3

2.0

0.5

0.7

0.7

1.5

0.4

0.5

0.5

110.

3

112.

011

3.9

116.

8

74.7

71.1

78.2

78.2

62.3

65.2

64.2

66.1

24.4

32.4

30.1

31.1

8.1

7.8

9.3

8.6

6.3

2.3

2.5

2.3

3.3

1.4

1.5

1.6

3.0

0.8

1.0

0.8

2.1

0.3

1.5

0.3

1.4

0.3

0.5

0.5

4.0

0.7

1.9

0.5

3.0

0.5

1.5

0.3

53.8

51.9

54.1

54.5

38.9

40.6

40.2

42.7

25.5

27.5

30.7

31.3

13.4

14.2

12.3

14.1

3.5

3.1

3.7

3.6

1.6

1.0

1.1

1.1

0.7

0.6

0.7

0.7

1.0

0.5

0.4

0.4

0.6

0.2

0.2

0.2

0.9

0.4

0.4

0.4

0.5

0.2

0.1

0.01 0.3

0.1

0.1

0.00

4

19.1

21.2

23.5

23.5

14.8

16.2

18.7

19.1

10.7

11.2

12.2

11.9

3.8

4.4

3.5

4.9

1.7

2.1

2.1

2.1

1.1

0.4

0.4

0.4

0.7

0.3

0.3

0.3

0.4

0.1

0.1

0.08 0.2

0.06 0.1

0.2

0.6

0.2

0.2

0.2

-0.5

0.08

0.06

0.07 0.3

0.06

-0.0

20.

07

65.1

66.7

70.5

65.4

53.5

55.4

58.9

53.1

33.2

34.2

33.6

32.8

13.7

15.6

13.9

13.2

4.2

3.9

4.2

4.4

4.2

1.4

1.5

1.4

2.1

0.8

0.9

0.9

2.1

0.5

0.6

0.6

1.0

0.3

0.2

0.2

1.1

0.3

0.3

0.4

1.9

0.5

0.4

0.4

1.5

0.4

0.3

0.3

47.7

40.5

52.0

49.5

37.1

30.4

43.5

40.7

19.5

17.9

18.9

22.6

12.5

12.3

18.9

15.1

3.2

3.3

3.3

3.2

2.6

0.8

0.9

1.0

1.8

0.6

0.7

0.9

0.8

0.2

0.2

0.06 0.6

0.1

0.2

0.2

0.7

0.2

0.3

0.3

0.1

0.08

0.05

-0.0

9

0.06

0.00

80.

02-0

.01

30.7

31.4

34.9

38.8

22.8

22.9

26.2

29.4

19.7

21.5

22.7

22.5

1.6

2.9

2.7

3.0

3.0

3.2

3.3

3.4

1.5

0.6

0.6

0.7

0.7

0.3

0.3

0.4

0.8

0.3

0.3

0.3

0.6

0.2

0.07 0.2

0.7

0.2

0.2

0.3

0.6

0.3

0.2

0.2

0.4

0.2

0.1

0.1

111.

7

119.

512

8.1

136.

9

83.6

92.0

98.0

100.

1

50.2

51.6

54.0

59.6

25.4

32.5

22.4

22.5

8.8

10.0

7.2

8.5

7.0

2.4

2.5

2.8

1.7

0.5

0.6

0.7

5.3

1.9

1.8

2.1

2.4

0.7

0.7

0.7

2.3

0.8

0.8

0.7

5.4

1.7

1.7

1.8

4.0

1.3

1.2

1.3

76.5

79.5

85.8

89.1

53.1

50.6

55.4

61.9

39.2

41.4

44.1

47.9

19.8

20.2

16.6

18.1

5.8

6.2

5.4

6.0

5.6

1.9

2.2

2.4

2.0

0.9

1.0

1.1

3.6

1.0

1.2

1.3

2.6

0.6

0.7

0.8

3.0

0.8

1.1

1.0

2.6

0.7

0.6

0.8

1.5

0.3

0.6

0.5

59.6

66.7

69.4

69.0

47.0

51.8

51.5

53.1

32.9

36.7

38.0

39.5

13.0

16.8

13.1

15.4

4.1

4.5

5.0

5.4

4.4

1.4

1.6

1.8

1.6

0.5

0.6

0.7

2.8

1.0

1.0

1.1

1.5

0.4

0.4

0.3

1.7

0.5

0.5

0.6

2.1

0.7

0.7

0.7

1.3

0.4

0.5

0.4

8.2

7.9

7.7

6.7

5.7

5.4

5.4

5.6

0.7

0.6

0.5

0.4

1.9

1.9

0.9

1.8

1.4

1.4

1.4

0.7

0.3

0.1

0.1

0.1

0.2

0.06

0.06

0.05 0.1

0.05

0.04

0.05 0.3

0.02

0.01

0.06 0.5

0.07

0.06 0.8

-0.0

2

0.00

6-0

.09

-0.7

0.06

0.00

6-0

.09

-0.7

44.9

45.4

46.6

45.2

33.4

32.0

33.6

33.2

27.7

29.7

30.3

29.2

6.1

6.1

5.6

5.1

2.8

2.9

3.1

3.3

1.5

0.9

0.9

0.9

0.7

0.6

0.6

0.6

0.8

0.3

0.3

0.3

0.3

0.1

0.1

0.1

0.5

0.2

0.2

0.2

0.5

0.2

0.3

0.2

0.4

0.2

0.2

0.2

13.3

16.0

15.2

15.5

8.6

10.5

10.6

10.8

5.7

6.9

6.5

7.6

0.6

0.6

0.8

0.5

2.2

2.2

2.3

2.4

0.7

0.2

0.3

0.3

0.4

0.1

0.1

0.1

0.3

0.09 0.1

0.1

0.2

0.04

0.05

0.05 0.3

0.09 0.1

0.1

0.2

0.06

0.06

0.07 0.2

0.02

0.07

0.04

Ban

k of

Pun

jab

Ban

k of

Khy

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20

Market AnalysisThe last four years have seen corporate earningsgrowth surge by a CAGR of 44% (2001-2005),in line with overall economic recovery, whilethe KSE-100 has jumped by a CAGR of 66%during the same period. As most of theeconomic growth has been driven by consumerspending, this has been reflected in both thetopline and bottomline of the corporate sectorduring this period. However, corporate earningsare now beginning to appear increasinglyvulnerable, as profit margins have little roomto expand (but more to shrink) while volumetricgrowth opportunities appear limited in the nearterm due to cooling of demand and expansionsin capacity/increasing competition.

An analysis of the major sectors indicates thatcorporate earnings and therefore equity returnswill be increasingly vulnerable in 2007. Coolingof global economic growth and increasingdomestic competition is driving prices downin sectors such as E&P, OMCs, Telecoms, andCement, threatening revenue growth goingforward. Moreover, demand is decelerating insectors such as Banks, capacity/supplyconstraints are limiting growth in the Fertilizerand Gas Marketing sectors while the OMCsector continues to suffer on account ofshrinking volumes.

Persistent inflation and a growing externaldeficit have increased the likelihood of a weakerPak Rupee going forward, which will directlyimpact the margins of sector such as AutoAssemblers while making the market lessattractive for foreign portfolio investors. Onthe brighter side, major sectors including E&P,OMCs, IPPs and Telcoms (to a lesser extent)provide a fairly strong currency hedge. Anotherkey risk to corporate profitability going forwardis the upward pressure on interest rates. Whilemost major sectors are relatively unleveraged,the Cement, Fertilizer and Gas Marketingsectors are significantly exposed due to theirhigher leverage ratios. On the flip side, theAuto Assembling and the E&P sector actuallybenefits from higher interest rates due to veryhigh cash balances.

Time toadopt amoredefensive-bias

Invest-mentstrategy

A stellarbeginning

We recommend investors to adopt a defensivebias while seeking value in growth sectorsduring 2007. In this regard, we recommendoverweight exposures to defensive sectors whilewaiting for value opportunities in growthsectors.

· Defensive: Our top defensive sectors are IPPsand Fertilizers.

· Growth: Our favorite growth sectors includeE&Ps, Banks and Auto Assemblers.

Perhaps as importantly, we believe that sizewill matter increasingly and recommendcompanies that have the economic scale tosucceed going forward, are industry leadersand enjoy strong local franchises. Our top picksfor the year are HUBCO, FFBL, PPL, NBP, MCB,Lucky Cement and Pak Suzuki although werecommend waiting for value opportunities,especially in banking stocks which appearexpensive at current levels.

Market Review 2006: A lackluster year

Following a 3-year (2002-2005) stint as one ofthe best performing markets in the world, 2006ended with the benchmark KSE-100 posting alackluster return after touching an all time highof 12,273 in April 2006. The market continuedto depict high volatility during 2006 but unlikethe previous four years, the KSE-100 posted alackluster return of 5.1 (up 484 points to 10,040on an average daily volume of 257m shares).The market rally that began near the end of2005 continued for the next three-and-a-halfmonths into 2006. During this period fromJanuary 1 to April 17, 2006, the KSE-100surged 28 or 2,717 points to a record high of12,273 on an average daily turnover of about450m shares. The rise in the index during thisperiod can be attributed to the following factors:

· Bellwether sectors such as banking and oil andgas exploration and production posted strongannual/quarterly earnings growth.

· Rising international crude oil prices and news ofdiscoveries led to surging stock prices of E&Pscrips such as OGDC, PPL and POL.


21

The crashof April2006

Lack-lusterclosing

· Settlement of PTCL privatization transaction led tospeculative activity in other state-owned units such asPSO and the two gas utilities (SNGPL and SSGC).

· A sharp increase in foreign portfolio investment.

After the KSE-100 reached its all-time closingpeak in mid-April, the market took a suddencorrection in the run-up to the FY07 FederalBudget which led to a shattering of investorconfidence. From April 17 to June 14, the indexplummeted 3,500 points or 29% to reach the2006 low of 8,768 on average daily turnoverof 222m shares. The major reasons for the bearmarket during this period were:

· Profit taking by both local and foreign investors.

· March-end quarterly earnings announcements ofmajor companies such as PTCL, MCB, PSO andNishat Mills were below market expectations.

· Negative reaction by the brokers to the FederalBudget FY07 because of the doubling of CVTand withholding tax on shares to 0.02% and0.01%, respectively.

· Global monetary tightening and interest rateincreases by the Federal Reserve in the U.S. andthe Bank of England.

The market during the second-half of CY2006was mixed and lackluster. The KSE-100 stageda strong recovery from mid-June to mid-Octoberand the index jumped by about 2,800 points or32% to 11,566 by October 19, 2006. The mainfactors behind this recovery were excellentFY06 and 3Q06 results reported by majorsectors such as banking, oil & gas E&P, and,oil marketing; resumption of Indo-Pak peacetalks; M&A rumours and developments in thebanking sector; placement of MCB Bank's GDRand sizeable inflow of foreign portfolioinvestment.

However, this recovery could not be sustainedfor the rest of the year as the market experiencedcorrection alongwith thin trading because ofapprehensions regarding the new riskmanagement regime; negative reaction to theforensic report on the March 2005 market crash;and, placement of OGDC's GDRs at a 10%discount to the local market price.

Market outlook 2007: Bumpy ride ahead

Key factors that in our opinion are likely toguide the market's mood in 2007, include thedirection of international oil prices; persistenceof inflationary pressures, which are drivingexpectations of continued monetary tightening;growing fiscal and external imbalances;slowdown in corporate earnings growth; and,the much needed yet widely disliked equitymarket reforms. On the political front, we feelthat the upcoming elections are likely to causea degree of increased uncertainty in the market.

However, we also feel that the reforms initiativeof the current government is likely to continueirrespective of the constitution of any newgovernment following the elections. On thebrighter side of things, we feel the wideningof the investor base through expansion in themutual fund sector and the increased foreignportfolio interest in Pakistan is a major positivefor the market.

Although Pakistan is an oil importing country(high oil prices have been a major factor behindthe widening of the current account deficit),E&P companies represent nearly 30% of totalmarket capitalization while the sectorcontributes only 2.5% to the country's GDP.With local pricing of E&P, refining and oil andgas marketing companies linked to internationalproduct prices, local equity market stand togain from rising oil prices. In fact, steadilyrising oil prices were the main driver of strongequity market performance during 2005.

Subsequently, the reversal in the direction ofinternational oil prices, which peaked at aboutUS$ 78/pbl in July 2006 only to tumble to therange of around US$ 60/pbl by September, hasbeen one of the reasons for the poorperformance of oil stocks during 2006.

With promising exploration and productionactivity expected in the coming years, localequity markets offer an attractive energy play.OGDC, the largest E&P company in the countryis expected to spend around US$ 1.9 bn onexploration and development programs and istargeting to increase oil and gas production by

Declininginter-nationaloil prices:Good fortheeconomy,not so forthemarket


22

Economicconcerns:Risinginflation-ary press-ures andmacroeconomic im-balances

Economicgrowth

Monetarypolicy &inflation

Double digit food inflation has so far keptheadline inflation above the central bank'starget. However, the trend in core inflation,which has gradually crept to around 6%, hasbeen more positive. Going forward, we feelthat headline inflation is likely to remain highespecially if fuel prices are not reduced in linewith the decline in international oil prices.

Rapid deterioration in the trade account hasled to a sharp jump in Pakistan's current accountdeficit, thereby increasing concerns of futureweakness in the exchange rate. While coolingaggregate demand has helped slow the pace ofgrowth in imports, performance of exports hasbeen even poorer. Accordingly, the SBP expectsthe current account deficit to deteriorate to4.2% of GDP in FY07 (FY06: 3.9%).

We believe that under the circumstances, thecurrent year's deficit will likely be financedfairly comfortably given the privatization andGDR pipeline, FDI and Portfolio investmenttrend and strong growth in remittances. However,a current account deficit over 3% of GDP willbe difficult to sustain in the medium term.

Following several years of robust profitability,earnings growth in some major sector hasdecelerated sharply and in some cases, earningshave actually fallen. Foremost among these arethe Cement and OMC sectors. Cements, whichhad been enjoying strong profitability on theback of robust demand and firm prices, haveseen profitability evaporate as massive capacityexpansions have led to a price war amongstmajor players.

OMCs have also been posting record earningsgrowth on the back of steadily risinginternational oil prices, which have resulted inwindfall gains in the shape of inventory gainsdespite flat sales volumes. More recently,international oil prices have reversed indirection, causing major inventory losses forthe large OMCs.

With little room for improvement in marginsof major sectors (and lots on the downside),we feel that vulnerability of corporate earningswill remain a key theme in the market and willadd to volatility in share prices during 2007.

Balanceofpaymenttroubles

Corporateearningsgrowth: Areversaloffortunes

13% per annum for the next three years. SinceJanuary 2003, the KSE-100 has been movinglargely in tandem with international crude oilprices. From January 2003 to present, the KSE-100 has jumped by about 290% while ArabLight crude oil prices have doubled during thisperiod. Nonetheless, earnings are highlyvulnerable to any major fall in international oilprices and we have assumed that internationalcrude oil prices will decline gradually at anannual rate of US$ 5/pbl to settle around US$45/pbl by FY11.

While the long-term growth outlook of theeconomy remains positive, the immediatechallenges facing the economy are likely todominate market concerns in 2007. Theseinclude deceleration of growth in real sectors,persistent inflation, a burgeoning currentaccount deficit, and a growing budget deficit.

The country has experienced a robust economicrecovery from FY01 when the real GDP growthrate was only 1.8 percent. The growth rate hasbeen averaging around 6 percent per annumduring the last 5 years while the last 3 yearaverage has been around 7.5 percent ascompared to an average annual GDP growthrate of 4.6 percent during the 1990s. Thegovernment is forecasting real GDP growth forthe current fiscal year (FY07) to be around 7percent, which we believe will likely beachieved if the agriculture sector performsaccording to expectations.

The State Bank pursued a highly accomm-odative monetary policy back in FY03 whenit decided to reduce its sterilization activity inthe forex market to bring down lending ratesfurther. The resultant increase in market liquidityand the SBP policy stance helped bring interestrates down to all-time lows. This triggered aneconomic revival and ultimately contributedto the stunning net private sector credit growthfrom Rs.48.6bn in FY01 to Rs.337.4bn in FY06.However, a policy reversal took place in FY05by the SBP to a tight money policy as theeconomy showed signs of overheating. Theimpact on the equity market was felt this yearas the KSE-100 has shed 12% from its all-timehigh closing of 12,273 on April 17, 2006.


23

The markets have embarked on a number ofreforms since the late 1990s in order to manageand reduce systemic risk, improve thefunctioning of capital markets and enhanceinvestor protection. The Asian DevelopmentBank's Capital Market Development Program(approved by the ADB in 1997 for US$ 250m)was the first major intervention to reform thenon-bank financial sector implemented over1997-2001. The main achievement under theCMDP has been the establishment of aneffective regulator in SECP in addition toimprovements in the technological infrastructureof capital markets. The next generation ofreforms consists of introducing marginfinancing, strengthening broker marginrequirements and demutualization andcorporatization of the exchanges.

The SECP has proposed several risk manage-ment measures to strengthen the existingframework deployed at the exchanges withinthe country. The new rules addresses VaR basedmargining system, netting of exposures, themechanism for marking to market of exposuresand valuation of securities eligible as collateral.

A new margin system based on 'Value atRisk'(VaR) has been introduced at the boursescompared to the previous system which wasbased upon different slabs, discounts (Hair-cuts) lower of the 52-week average price andthe current price. VaR is defined as themaximum amount of money that can be loston a portfolio over a given period of time, witha given level of statistical confidence.

It is proposed that the netting of exposures notbe allowed unless (1) netting is in the samescrip on the same day and for the same client(within Ready Market), (2) netting is betweenbuy and sell positions in the same scrip, for thesame client and in the same contract period(within Futures Market - Deliverable Contracts)and (3) netting is between buy and sell positionsin the same scrip for the same client during thesame contract period and in the same market(within Futures Market - Cash Settled SingleStock Futures Contracts). The only exceptionis in the CFS Market and Ready Market, wherea CFS broker finance may have an open readymarket sale position and an open CFS purchase

Capitalmarketreforms

Margin-ingsystem

Nettingforexposurepurposes

Mark-to-Market(M2M)loss coll-ection andprofit dis-tribution

Valuationofsecuritieseligible tobe held assecurity(collater-al)

Wideninginvestorbase

position in the same scrip with settlement ofboth open positions being on the same date.

For the purpose of M2M, profit/ loss is to becalculated at the end of each trading day at the'Daily Settlement Price.' Netting will only beallowed in profit and losses of the same clientor proprietary position in different scrips butnot in contract of different periods.

Contrary to the earlier practice which onlyconsidered turnover and EPS of the scrip againstdeposit, it is proposed that all securities shouldbe categorized on measures of liquidity andvolatility. Furthermore, software deployed bythe NCEL will categorize stocks into 3 broadgroups based upon percentage of days tradedduring the last 6 months and impact costs.Securities eligible for collateral will becategorized using VaR calculations withdifferent hair-cut rates being applicable todifferent categories (i.e. the more risky asecurity, as measured by VaR, the higher theapplicable hair-cut). While the aforementionedmarket reforms are expected to be positive forthe market as they will help reduce systemicrisks, the short-term impact will likely benegative in the shape of reduced tradingvolumes.

The last 5 years has seen increased participationin the capital markets by both domestic retailinvestors and foreign institutions which havehelped boost the liquidity situation in themarkets. The rise in the number of mutual fundsover the past 5 years in Pakistan has beendramatic. In FY01 (July-June), the number offunds were 17 and net assets under managementwas only Rs.25.1bn (US$ 418m) and by theend of FY05, the number of funds has doubledto 33 with Rs.124bn (US$ 2bn) of net assetsunder management (NAUM).

Likewise, foreign institutional investment inthe equity market has surged over the last 5years. From a foreign portfolio investmentoutflow of $140.4 mn in FY01, it has risen toan inflow of $351.5mn in FY06. The net inflowfor 6mFY07 comes to US$ 278m. With therecent placement of MCB Bank and OGDC GDRs,the country's profile among international investorsis expected to be enhanced going forward.


24

Books ReviewIncome Tax Law Plus PracticalProblems with Solutions 2006-07Prof Dr. Khawaja Amjad Saeed

Pakistan is in search of a fiscal policy which canensure an accelerated tempo of domestic resourcemobilization to not only meet the currentexpenditure at federal level but also contributesubstantially towards financing annualdevelopment plans. The financing of the federalbudget depends substantially on external assistance.This has had to large external debts, posingdifficulties for the balance of payments.

The Federal Government generates its revenuesthrough direct and indirect taxes and through thenon-tax revenue sources. The book under reviewrelates to income tax. Based on available statistics,there are around 1.4 million income tax payers inPakistan of a population of 160 million. This callsfor immediate attention, for evidence availablesuggests the untapped number of income tax payersto be around five million.

The book consists of two parts; the first deals withthe income tax law in detail, and the second partwith some of the problems covering assessmentof individuals, companies etc. Easy to comprehendnotes on the Finance Act, 2006 issued by the CBRhave also been included in the book. Amendmentsto the Income Tax Ordinance 2001 have also beenincluded.

Human Development Report 2006

This year’s Human Development Report looks atan issue that has a profound influence on thehuman potential and progress towards theMillennium Development Goals.

Access to water is a basic human need, but morethan one billion people are denied the right toclean water and 2.6 billion people lack access toadequate sanitation. Every year some 1.8 millionchildren die as a result of diarrhoea and otherdiseases caused by un-clean water and poorsanitation. In many countries young girls go outto collect water for their families, which deniesthem the opportunity to education and gainfulemployment. Lack of water and sanitation resultsin ill-health and undermines productivity andeconomic growth.

This year’s Report shows that though the problemsvary by country, but several issues emerge. Thesehave been discussed in detail. There is limitedbudget allocations for water

and sanitation. Second, some of the world’s poorestpeople are paying some of the world’s highestprices for water, reflecting the limited coverageof water utilities in the slums and informalsettlements where poor people live. Third, theinternational community has failed to prioritizewater and sanitation in the partnerships fordevelopment, that could integrate around theMillennium Development Goals. Underlying eachof these problems is the fact that it is the poorpeople and women who suffer the most and theyoften lack the political voice needed to assert theirclaims to water.

The Report has examined these challenges andhas shown that many countries have made goodprogress in providing clean water and sanitation.Many of those living in the developing world havemobilized resources and initiated some innovativeschemes to tackle their problem. The developingworld today has the finance, technology andcapacity to consign the water and sanitation crisisto history. What is needed is concerted efforts toextend access to water and sanitation to all throughwell designed and properly financed national plans.

The State of Pakistan’s Children 2005 SPARC(Society for the Protection of the Rights of theChild)

SPARC, a non-profit organization is trying toimprove the lot of children in Pakistan byhighlighting their plight, writing and disseminatingpublications on various subjects relating to themand pressing relevant governmental quarters to dosomething for the children of this country.

The Report 2005 presents a range of issues whichaffect our children, with a chapter on theconsequences of the October 2005 earthquake onchildren. The other chapters are on education,child labour, health and survival, violence againstchildren, the plight of children in prison. A largenumber of Pakistan’s children suffer from lack ofeven reasonably equitable access to healthcareand education. Millions work in hazardousoccupations in the country and miss out oneducation and with it, the major means throughwhich they could have been set free from theclutches of poverty.

They are subject to violence and all kinds ofexploitation, trafficking. These traumaticexperiences leave life long scars affecting thechild’s daily life.

BULLETIN - National Bank of Pakistan

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